Looking Into the Federal Reserve's Mind

WASHINGTON (Dow Jones)--Six weeks after stunning world financial markets by slashing interest rates to near zero, Federal Reserve officials are expected to dial back the drama this week with rates on hold. --Still, Fed watchers will eye the accompanying policy statement at the conclusion of the two-day meeting on Wednesday for any updates on the Fed's myriad lending programs. Of special interest will be an idea officials have repeatedly floated, about buying longer-maturity Treasury securities in a bid to improve conditions in credit markets. --In the Dec. 16 policy statement, the Federal Open Market Committee said it was "evaluating the potential benefits of purchasing longer-term Treasury securities." Fed Chairman Ben Bernanke had said something similar in a speech two weeks before that meeting, and has repeated it since. --But putting it in the statement binds the Fed to that idea, and Fed watchers will scrutinize each word to gauge if such a plan is closer to being executed, especially with Treasury yields on the rise in recent days. --"There is a risk, when you say something so many times, it becomes read not as a contingency plan, but as a commitment," said Vincent Reinhart, former head of the Fed's monetary affairs division who is now with the American Enterprise Institute. "They're pretty close" to that on Treasury purchases, he said. --As Michael Feroli, economist at JPMorgan Chase notes, the Fed faces risks with both repetition and omission. If they repeat what they said six weeks ago, "it'd be like, hey how long do you have to study it?" he said. --Meanwhile, "if they don't mention (buying) Treasurys at all, the market's going to sell off massively," Feroli said, since investors might assume the idea is off the table. --A big argument for largely sticking to the notion of studying the idea is that Bernanke's semiannual monetary policy testimony to Congress is coming up in a few weeks. That's a better venue to go into the specifics of such a plan than a few words of an FOMC statement. --"Part of the meeting dynamics is a temptation to say, 'Well, Mr. Chairman, you can say this more fully in your testimony,'" Reinhart said. --Last month, the Fed surprised Wall Street by cutting the target fed funds rate for interbank lending from 1% to a range near zero. The Fed also said that the weak economy was "likely to warrant exceptionally low levels of the federal funds rate for some time." Fed watchers took that to mean that rates will stay near zero perhaps into 2010. --So with rate changes off the table, officials are left with the Fed's burgeoning balance sheet to boost the economy. Last month, the Fed devoted considerable space in its policy statement to its balance sheet, including a $500 billion mortgage-backed securities program that began in January and an asset-backed one due to begin next month. --"The Fed might, in the context of an upcreep in Treasury and mortgage rates, want to place particular emphasis on its plan to purchase mortgage securities and possibly Treasury securities," said Miller Tabak strategist Tony Crescenzi. --Meanwhile, economists expect few changes to the Fed's assessment of the economy. In its Dec. 16 statement, the Fed said that "available data indicate that consumer spending, business investment, and industrial production have declined" while "the outlook for economic activity has weakened further." Little has changed since then, except that the contraction in first-quarter gross domestic product will likely be even more pronounced than had been expected by economists a few weeks ago. --However, if officials want to jawbone market interest rates down a bit without committing to a massive new Treasury purchase program, they could tweak their language on inflation to show more concern about outright price declines, known as deflation, or at least the risk of inflation being too low for their comfort. --Last month, officials said they expect inflation "to moderate further in coming quarters." But the minutes of that meeting, released three weeks later, signaled more concern. "Some members," the minutes said, "saw significant risks that inflation could decline and persist for a time at uncomfortably low levels." --Earlier this month the government reported that consumer prices inched up just 0.1% in 2008, the smallest calendar-year increase since the 1950s. --"I think they'll avoid the word deflation, but they have good reason to express concern about further unwelcome disinflation," Reinhart said. (Brian Blackstone is a special writer at Dow Jones Newswires who covers the economy and the Federal Reserve. He may be reached at 202-828-3397 or brian.blackstone@dowjones.com.) (TALK BACK: We invite readers to send us comments on this or other financial news topics. Please email us at TalkbackAmericas@dowjones.com. Readers should include their full names, work or home addresses and telephone numbers for verification purposes. We reserve the right to edit and publish your comments along with your name; we reserve the right not to publish reader comments.) 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